What should I do with my pension tax-free lump sum?

More than half (54%) of people approaching retirement plan to take the 25% of their pension pot that they are allowed to take as tax-free cash. With the average person aged between 55 and 65 having saved in pensions, this means they can look forward to a one-off tax-free lump sum worth £26,374 - almost equivalent to the average UK salary.

What retirees do with the cash

You can spend this money as you wish but according to Aegon research, one in six (17%) people will put their money into a cash ISA and 15% will put it in a bank account. A further 14% plan to use the money to take a holiday, 12% are thinking about purchasing a property and one in 10 will use the savings to clear debts.

25% tax-free cash popular with retirees

Steven Cameron pensions director at Aegon says the ability to take up to 25% of your pension tax-free has always been a popular option with retirees: "The option is intended as an incentive to save through a pension and often allows people to fund the early part of their retirement and to make the most of their new-found freedoms. It’s particularly beneficial to those whose retirement incomes are likely to exceed the tax-free personal annual allowance of £11,500."

More choices for your lump sum

Arguably the decision to take cash this way at retirement has become more complicated since the introduction of the pension freedoms. Previously the majority of people took their cash and then bought an annuity with the remainder. Now people can access their savings in a variety of ways, including by keeping them invested and drawing an income, or by accessing it all as cash either in one or multiple goes.

When to take the money

However, Steven Cameron says retirees need to think carefully when deciding whether to take their maximum tax-free cash lump sum immediately or leave more of their money invested.

He explains: "For some people the cash received is vital to clear debts, perhaps pay off a mortgage or clear a credit card. However, not everyone needs it as soon as they retire and money left invested in the pension will continue to grow tax-free while also offering beneficial inheritance tax aspects."

Savings vs leaving money invested

Cash ISA rates and returns on savings accounts are at all-time lows, with the combination of inflation and low interest rates effectively eating away at spending power from these accounts. Yet, nearly a third of people plan to put the money in a cash ISA or a bank account and Steven says this raises a red flag: "Savers have worked their whole life to put money away so should be wary of leaving it languishing in bank accounts which aren’t returning the favour. Delaying taking it until they really need it might be a more sensible option."

6 top tips for taking your tax-free pension lump sum

  1. Check what kind of scheme your pension savings are held in. The rules for taking a tax-free lump sum are very different for Defined Benefit and Defined Contribution pension schemes.
  2. Do you need one large lump sum? If you can keep the money invested in your Defined Contribution pension and take smaller amounts each year, you may be able to opt for 25% of each of these payments to be tax-free and this has the added benefit that the remaining money will gain from any investment returns before you take it. You only have this option before you move your pension into an annuity or income drawdown product.  Retirees thinking about this should check that their scheme or provider offers this and any associated fees.
  3. You may be entitled to a higher ‘protected’ percentage tax-free from some older types of pensions – check with your provider or scheme. This may affect how you decide to take your tax-free cash sum.
  4. Before you put the money in a bank account, review the current interest rates on savings accounts and cash ISAs and compare them to the potential investment returns on your pension savings. Pensions tend to be invested in stocks and shares. Remember, the value of an investment can fall as well as rise and isn’t guaranteed. You could get back less than you originally invested
  5. Carefully consider inheritance planning in any decisions about your pension savings. As soon as money is accessed it is then subject to inheritance tax as part of a person’s estate but pension savings are treated differently. If death occurs before age 75 pension savings can be passed on tax-free and if over age 75, tax is paid at the income-tax rate of whoever inherits the pension pot.
  6. Seek professional advice This can be a complex area and getting it right can offer real benefits.